Short Stories: Profiting from the subprime mortgage bust

Posted Dec 18th 2006 4:25PM by Peter CohanPeter Cohan RSS Feed
Filed under: Short Stories

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Although short selling -- the practice of selling borrowed shares with the hope of repaying the loan by buying back the shares at a lower price -- goes against the American belief that stocks always go up, I have long been fascinated with it. My plan for my new blog series, Short Stories, is to discuss what works, what doesn't, and what some of the leading lights in shorting stocks think about its opportunities and threats. I will describe possible short trades and I'll seek your comments and questions for story ideas. I won't be offering any investment advice and I won't trade on any of the posts I write.

Want to profit from the real estate tumble? One way is to short stock in companies that make mortgages for those with less-than-perfect credit. In recent weeks, two such subprime mortgage lenders -- Ownit Mortgage Solutions and Sebring Capital -- closed up shop.

And shorting NovaStar Financial, Inc. (NYSE: NFI) may be a good way to play this trend. How so? Compared to five of its publicly-traded peers, NovaStar -- a Kansas City, MO-based originator, purchaser, investor and servicer of mortgages to borrowers with substandard credit -- looks to be in the most trouble. At 32.1%, more of NFI's shares have been sold short than those of peers such as Accredited Home Lenders Holding Company (NASDAQ: LEND), New Century Financial Corp. (NYSE: NEW), Impac Mortgage Holdings, Inc. (NYSE: IMH), Ocwen Financial Corp. (NYSE: OCN) and Delta Financial Corp. (AMEX: DFC) which have short interest as a percent of outstanding shares of 26.4%, 23.3%, 11.1%, 6.5%, and 4.3% respectively.

Not only does NFI have a high short interest, but on December 15th Jim Cramer's Blog found it near the top of TradingMarkets Options's Put Volume Alerts list which suggests "an extraordinarily negative earnings report, or other news which may negatively affect the stock."

On the surface, things at NovaStar look fine. Its $300 million in sales have grown at a 44.5% average rate over the last five years and its net income of $137 million has spurted up at 107% per year over the same period. It pays a whopping 18.3% dividend yield. (As a real estate investment trust (REIT), NFI must pay at least 90% of its taxable income as dividends every year.)

But short sellers are betting that recent and potential negatives will make them money. Here are some possible reasons:

  • Rocky fundamentals. NovaStar's stock has lost 3.2% of its value in the last year. Its balance sheet sports $8 of debt for every dollar of equity,1.6 times the mortgage investment industry average. And in the last year, its earnings have plunged 32%.
  • Spiking credit problems. Things are getting bad fast for NovaStar. It increased its provision for credit losses 20-fold from $1 million in the nine months ending September 2005 to $20 million for the same period in 2006 -- reflecting its anticipation of an increase in bad loans. And it raised 24-fold its allowance for credit losses in the mortgages its retains on its balance sheet -- from $700,000 in September 2005 to $17.6 million in September 2006.
  • Big debt repayment obligations. NovaStar must repay $3 billion ($2.6 billion of long-term debt and $300 million worth of junior subordinated debentures). Specifically it must repay $898 million in 2007, $1,257 million between 2008 and 2010, $482 million between 2011 and 2012, and $356 million in 2013 and beyond. NFI burned through $83 million in cash in the most recent quarter leaving it with $182 million worth of cash -- insufficient to meet its 2007 debt repayment obligations.
  • Potential loss of short-term liquidity could make it tough for NovaStar to repay these debts. It's happened before. For example, in October 1998, the subprime mortgage loan market faced a liquidity crisis -- losing access to short-term borrowings from big banks and long-term borrowings through a process of packaging and selling mortgages -- known as securitization. This hurt NovaStar's operations in 1998 and it hurt the banking industry as well. For example, according to the Federal Deposit Insurance Corporation, five of the nine banks that failed in 1998 or 1999 had significant subprime portfolios.
  • Scary trading pattern. Based my limited experience -- using the techniques I described last week -- it appears that NFI is likely to continue to drop. As this chart demonstrates, last week NFI fell far below its 200 day moving average on more than double its average trading volume -- suggesting that some major traders know something about NFI which is likely to cause its stock to decline. Carter Worth, Chief Market Technician at Oppenheimer & Co., looked at the chart and his e-mail reply was "NFI: Sell." As of the end of September, the most recent data available, big holders like Dreman Capital Management -- which owned 5.5% of NFI -- sold 16% of its shares and Goldman Sachs -- which held 3.3% of NFI -- sold 35% of its position.

There are some positives to the stock, however, including:

  • Possible short squeeze. The danger of NFI's 32.1% short interest is that if the stock goes up, short sellers get into a buying panic as they rapidly buy more shares to cover their positions.
  • Earnings growth. If consensus earnings per share (EPS) forecasts are correct, NFI's EPS will grow 7.6% between 2006 and 2007 to $3.82/share. Trading at a forward P/E of 8.2, the stock appears reasonably priced.

Nevertheless, if the short sellers are right, at $29 NFI has a long way to fall.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College. He has no financial interest in Accredited Home, Delta Financial, Impac Mortgage, New Century Financial, Novastar, or Ocwen Financial.

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